INDUSTRY OVERVIEW OF LUXURY FRACTIONALS AND PRIVATE RESIDENCE CLUBS APRIL 2005 By HOBSON REAL ESTATE ADVISORS (condensed) INTRODUCTION In 2004, the second home industry in North America, Mexico, the Caribbean, and Hawaii achieved record sales volumes. A total of 2.82 million second homes were sold in the U.S., up 16.3% from 2.42 million sales in 2003. Baby boomers are the 76 million Americans born in an 18 year time span between 1946 and 1964, who now represent approximately one third of the population of the U.S. The leading edge of the baby boomers have now reached age 59. This generation has dominated consumer demand for all products at every stage of its life cycle, and is now dramatically affecting demand for second home real estate. In response to growing demand the resort industry has undergone substantial change in the last five years. In order to broaden the market, new products have been invented to better respond to people’s needs and pocketbooks. Annual use of a second home averages only about three to four weeks per year, and even less, in many cases. Thus, second home ownership is impractical for about 80% of the households in the U.S. earning $150,000 per year or more. One of the most recent innovations in the second home industry is the introduction and rapidly increasing popularity of luxury fractional real estate, also called shared ownership. Fractionals serve two purposes and are a benefit to both the consumer and the developer. First, they lower the price point so the buyer is purchasing much higher quality than what they could otherwise afford, or they are being more practical and only buying what they have time to use. Second, fractionals broaden and diversify the market for the developer by creating lower price points and usually result in higher profitability when properly conceived and executed. TYPES OF FRACTIONALS There is industry confusion and semantic problems with the term “fractional” because there are several different types of fractionals that serve different markets. To better understand these differences it is important to note that there are two principal motivations for owning a second home; investment and enjoyment from use of the home. Timeshare A timeshare provide the owner with an annual vacation in the location of their choice in lieu of renting a hotel room or other type of rental property. Timeshare comes with extensive exchange privileges, usually through RCI or Interval International. Timeshare resales are often heavily discounted, so investment is not a purchase motive. There are two different timeshare business models. The traditional model is the fixed week interval where a fixed week is purchased for a price that generally ranges from $10,000 to $30,000. The buyer receives a right to use the property one week per year. The second model, which is rapidly gaining in popularity, is a point system where the buyer purchases a designated number of points that are renewed each year. The timeshare company owns and manages an inventory of homes in numerous resort locations and each year the buyer is able to select a week or more, depending on the number of points purchased, at the location of his choice. This system does not include a deed, but rather is a right to use. Private Residence Clubs                                      *Sueno del Mar* A PRC is designed to target and penetrate the same affluent market that would normally purchase, or aspire to purchase, an expensive luxury wholly owned second home. The buyer perceives they are making a real estate purchase and buying a vacation home, not an annual vacation. By sharing the ownership the buyer is purchasing only what he needs and can use, at a fraction of the price of whole ownership. The typical buyer is 45 to 65, married, often with grown children, incomes of at least $300,000 per year, and more importantly a net worth typically starting at $3,000,000. A residence club should not be confused with fractional condominium hotels, or any other type of resort rental product sold in fractional shares with a managed rental pool where rental income is a strong purchase inducement. PRC’s are seldom rented except for unsold developer inventory. Management does not facilitate or encourage rentals. If the owner rents any of his guaranteed weeks, the renter is treated as the owner’s unaccompanied guest. The PRC is designed to sell to an affluent market as an alternative to whole ownership of a second home. It is an emotional purchase and it should fit the image of the buyers “dream home.” When fractionalized the incremental cost of additional space and an extra bedroom is relatively modest compared to whole ownership. The market is price insensitive, and more concerned about how they can use the home. Although purchase decisions are not driven by investment objectives, the buyer perceives and expects they will receive approximately the same rate of value appreciation as whole ownership in comparable locations. To date this has not been the case with all clubs for various reasons. However, most residence clubs in good locations, in projects fully absorbed are reselling at prices higher than the last developer price. The fractional residence is usually large and luxurious and appointed with finishes and furnishings comparable to or better than, luxury whole ownership residences that sell for at least $1,000,000, and sometimes $5,000,000 or more. PRC’s are location sensitive and are most successful in the high end five-star resorts, with strong amenities like a world class resort area. PRC’s typically include a private clubhouse and five-star hotel services that are not available with wholly-owned resort real estate. The coupling of a private club with shared ownership in a vacation home is a trend that adds sophistication and a higher level of exclusivity to the product and a sense of belonging. The club functions like a private equity golf club where the members have the opportunity to interact and form social relationships with other members while in residence. Property management and hotel services are provided so people can relax while vacationing. The experience is like staying in a five-star hotel, except the member is an owner and pays annual homeowner association dues instead of renting by the night. In addition to the physical product, the developer of a PRC is selling a lifestyle experience. The residence club is marketed as a real estate investment. The emphasis is on relationship selling rather than mass-merchandising. It is a soft sell approach. Repeat visits prior to closing are the norm. The target market may have a negative impression of timeshare and will not respond to high-pressure sales tactics or sales gimmicks that are common in the timeshare market. Fraction sizes generally range from 1/6th to 1/12th and the buyer receives a fee simple deed to a residence in accordance with the fractional size of the PRC. A second form of ownership is a deed to all of the real estate in accordance with the total number of shares. Within the fractional industry, PRC’s represent the highest end of the market with share prices ranging from approximately $200,000 up to $1 million for a 1/8th share equivalent. Common areas are generally owned in condominium by all residence club owners. Unit designs include two relatively equal twin master bedrooms with somewhat smaller third and fourth bedrooms. However, each bedroom has its own private bath. A half bath is usually located somewhere off the living area. Great rooms are common and create a feeling of luxury and openness. Each home should have a small study or den with a desk for a home office. This room can also function as an overflow sleeping area with a hide-a-bed. Large outdoor living spaces connecting to the living area and the twin master bedrooms is also critical, particularly in warm climates where outdoor living is an important part of the lifestyle. Naturally, the land plan should orient as many units as possible towards the view amenity. Units should be designed with large floor to ceiling windows to provide unobstructed views. The amenity package should include a private members lounge with a check in area, management office space, a small outdoor swimming pool, and a small fitness room. Storage space is also needed with a storage locker for each member. There is a trend to enhance the amenity offering with private golf club memberships, while in residence, private yachts, fractional jet service, beach clubs, and other similar types of offerings. These types of lifestyle additions further enhance the marketability and perceived value of the PRC Warm weather climates with long seasons usually experience higher average annual occupancy than ski areas. Pricing Share prices are trending much higher together with larger sizes and more exclusive locations. In the 1990’s share prices were seldom over $300,000 and often began well under $200,000. Today, average prices for new PRC’s are in the mid $300,000’s and range up to $1,000,000. It is not unusual to find three and four bedroom residence clubs priced at over $500,000 per fractional share. Prices per square foot are also increasing and there are many projects selling for well over $1,000 per square foot in exclusive five-star national and international resort destinations. The highest price in the market is $3,600 per square foot. A select number of projects in the planning stages will sell for over $2,000 per square foot. The industry average is approximately $1,600 per square foot. On the average, most PRC’s will experience at least a 30% price increase between opening and the last developer price. It is a better strategy to begin with a lower price to help establish momentum and send a positive message to the market. Rapid absorption initially also creates more urgency to buy through excitement over the initial success of the offering. The number of units built should be structured around a realistic absorption target that will result in a sell out of no more than three years after completion, with two years being optimal. After two to three years members begin to resell their memberships and the developer must compete with these resales if the project has not been fully absorbed into the market. This condition can substantially slow new developer sales. FUTURE OF THE INDUSTRY The resort industry is entering a period of explosive growth. While sales will ebb and flow as economic cycles come and go, the long term trend will produce dramatic growth in the second home real estate industry. PRC real estate is a niche product within this industry that serves the needs of two markets. 1. There is an affluent market that can afford a whole ownership second home perhaps in the multi million dollar range. However, time constraints make second home ownership impractical. Many of these households have been sitting on the side lines, wanting the use of a second home for a few weeks per year, but not the responsibility and the corresponding investment in an underutilized asset. A variation of this market is the household that already owns a second home but feels guilty, due to infrequent use, and are tired of the responsibility. 2. Another market is the less affluent market that aspires to the status and luxury of a high priced second home, but cannot afford five-star quality. Thus, as the second home market grows, the PRC market will grow at least proportionately. An argument can also be made that the PRC market will grow much faster than whole ownership. First, the base is significantly smaller so the percentage of increase will be greater. More importantly, there are many more households that fall into the category of the two markets described above, than households who will only consider whole ownership. However, PRC’s will compete not only against whole ownership, but also against the other types of fractionals described in the first section of this report, with the exception of timeshare. The price point of timeshare is so far below other types of fractional real estate that the market is completely differentiated and noncompetitive. The concept appeals to the logic of the majority of working households for whom whole ownership of a second home is impractical. PRC’s provide a type of ownership that is not only affordable, but fulfills a dream.